UK DMO stresses need for consistency

With government budget deficits growing rapidly across Europe and in the US, sovereign debt issuance is facing ever more scrutiny. Robert Stheeman, chief executive of the UK’s Debt Management Office, talks to Michael Watt about the challenges he faces and the impact of new regulation

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Investors were last year forced to reconsider what had, until then, been a rock-solid assumption: that eurozone government debt is risk-free. The rescues of Greece in May and Ireland in November drummed home that debt-laden sovereigns were vulnerable, resulting in a raft of stability measures, including the European Financial Stability Facility (EFSF) – a vehicle that will issue eurozone member-guaranteed bonds to finance the bail-out of struggling countries.

The impact of these measures could reverberate well beyond the eurozone. Some have suggested EFSF debt could rank above individual sovereign debt in a default scenario, potentially having an effect on government bond markets, both inside and outside of Europe. Meanwhile, collective action clauses – where a haircut would be imposed on bond investors in the case of default – look set to be introduced for eurozone government debt after 2013. Again, this could influence demand for non-eurozone debt, with some suggesting it could make it more attractive.

The eurozone is not the only focus for change. The Basel Committee on Banking Supervision finalised Basel III last December, which among other things will introduce a new liquidity coverage ratio (LCR). This will require banks to hold a cushion of high-quality liquid assets from 2015 – and government bonds will make up the lion’s share of this buffer, in turn creating a captive audience for sovereign debt.

Like others, the UK Debt Management Office (DMO) is wrestling with all these issues, alongside challenges of its own. The agency is charged with raising £150 billion in the 2010/11 fiscal year, a slight drop from the £163.4 billion the year before, but substantially higher than the £37.5 billion in 2005/06. If that doesn’t pose enough of a test, it may soon have to develop a brand new inflation market, following a UK government proposal to use the consumer price index (CPI), rather than the retail prices index (RPI), for the revaluation and indexation of pensions (Risk September 2010, pages 28–31). Robert Stheeman, chief executive of the DMO in London, discusses some of these issues with Risk.


Risk: What is the DMO doing to encourage a good take-up of gilts over the next few years?

Robert Stheeman: I think people tend to forget we actually can’t force people to buy our debt – there is no magic bullet solution to ensure a good take-up. All we can do is ensure the distribution and communication channels with the markets are kept open. That involves talking to the primary dealer community to make sure they are doing whatever they can do to keep liquidity in the market. We also focus on maintaining an open dialogue with our investor base – financial institutions, trustees and pension funds, and overseas investors – to get a better sense of how their preferences are changing, so we can react quickly and efficiently. Our investors rely on a consistent, transparent and easily accessible market, and that is what we try to create.


Risk: To what extent can you change or refine your distribution mechanisms in response to market events?

RS: The amount of money we need to raise, and the broad outlines and mechanisms of how we go about doing so, are laid out in the government’s budget before the start of each financial year. Sometimes these goals are tweaked during the year, as happened when our borrowing level was reduced by £20 billion in the June 2010 emergency budget. However, we try as much as possible not to deviate from our strategy within the year. Our investors above all value predictability, consistency and transparency in the way we issue our debt.

We will only change our maturity structure or auction calendar if there is a very specific need. For instance, we’ve only twice had what we call a remit review – a complete change to our issuance structure. The last was at the end of 2008, when we needed to quickly raise an extra £30 billion quite late in the financial year to fund the recapitalisation of the banking sector. We ended up having to change the maturity plan we started the financial year with, and the proportion of debt raised in short-, medium- and long-term instruments. So we recognise the need to be flexible in extreme situations, but we are wary of chopping and changing too much because the market could raise our borrowing costs by pricing in an uncertainty premium.


Risk: Did you see any decline in demand for gilts throughout last year’s sovereign debt crisis?

RS: Interestingly, no. We’ve been relatively sheltered from the extreme moves seen in some parts of the eurozone bond markets during that time. If anything, the anecdotal evidence suggests we benefited somewhat from a flight to quality as people reacted to the perceived stresses within parts of the eurozone. Cover on our gilt auctions has held up very well over the past 12 months, and the market seems to have become much more stable through the start of this year.

In addition, since 2009, around 20% of our financing needs have been met via supplementary methods of distribution, such as mini-tenders and syndications. These have been very successful, and in the run-up to the new budget in March, we are giving serious thought as to whether we should continue with them.


Risk: Has the investor base for gilts changed in recent years?

RS: We have seen a change in the past few years, which is part of a longer-term trend. When I joined the DMO in 2003, the UK pension fund industry was by far the largest single part of our investor base, accounting for two-thirds of the entire gilt portfolio. While it remains important, this figure has declined. The gilt investor base is now split into three roughly equal portions: pension funds and other UK investors; overseas investors; and the wider banking sector, including Bank of England holdings.

The increase in overseas investor interest has been directly linked to the fact that our issuance is now more spread out across the maturity spectrum than at a time of very low gross gilt issuance. Ten years ago, we were focusing almost exclusively on long-maturity debt issuance, but we only needed to raise £10 billion. Now we need to borrow more, we issue far more in short- and medium-term gilts. This has made the market for UK debt far more liquid and international – for example, overseas institutions such as central banks tend to focus on instruments with maturities of up to 10 years. New investors are coming in from all over the world, and we think this broadening of our investor base is a very healthy development.


Risk: With inflation on the rise, will you be increasing your issuance of linkers?

RS: Given that the budget is so close, I’m not in a position to say what we are going to do next year. Inflation-linked bonds form more than 20% of our portfolio, which is the highest proportion of any developed country. They are already an integral part of our debt issuance programme.

Some people argue that, in an ideal world, all government debt should be inflation-linked. However, we don’t live in an ideal world and we have to ensure any instrument we issue is of sufficient liquidity and in enough demand. We continually consult with investors and market-makers, and there has been a call from them for inflation-linked issuance. We listen to these comments very carefully. If we find they are representative of the overall demand in the market and if we deem it to be cost-effective, we’ll certainly consider increasing issuance of that type of instrument.

 

Risk: The Department for Work and Pensions (DWP) has proposed using CPI rather than RPI to calculate annual increases in pension payments. Does the DMO plan to begin issuing linkers based on CPI?

RS: The DWP consultation on the CPI issue ends on March 2. As far as the DMO is concerned, we are ready to consult on CPI-linked issuance when the DWP makes its legislative intentions known. The market will, however, first need to have some level of certainty about the policy-making environment before it can respond intelligently to any questions from us as to whether they want to buy CPI-linked gilts.


Risk: What effect will CPI-linked issuance have on the existing RPI-linked market?

RS: That is one of the issues we need to consult with the market on. It throws up a number of issues: will the market want some sort of facility to change to CPI-linkers; how desirable is it to have a two-tier market split between newly issued CPI gilts and existing RPI gilts; what impact will CPI issuance have on market liquidity? We need to think very carefully about these questions, and a thorough consultation is required before we make any decision.

We’d also have to think very carefully about pricing the instrument. Price discovery is always a big issue for us, and we are very wary of being in a situation where we attempt to dictate a certain price level to the market that doesn’t reflect true supply and demand, because I don’t think that is sustainable.


Risk: As you mentioned earlier, the sovereign bond markets, particularly in the eurozone, seem to have stabilised. Are there any flashpoints on the horizon that people need to be wary of?

RS: The upcoming European Union summit in Hungary at the end of March will be very important, as they are going to try to finalise the technical provisions of the eurozone stability mechanism that will succeed the EFSF. This is an absolutely key issue – there is a lot of concern among German politicians about how it is going to work. Some people say the German constitution may have to be altered to allow it to purchase the bonds of ailing eurozone sovereigns.

 

Risk: There have been suggestions that EFSF instruments will rank above individual sovereign debt. What impact will the EFSF have on sovereign bond markets?

RS: I can’t see how that would work legally. Under the Basel III rules, all central government bonds are zero-risk weighted. Presumably, this weighting would apply to EFSF instruments. I just don’t think it will be possible for them to be ranked higher than individual sovereign debt issuance in risk capital terms.

Even if this were to happen, I don’t think our programme would be much affected. It is conceivable that investors may prefer EFSF debt to that of individual eurozone members, but I think we’ll be fairly immune from this problem because we issue in a different currency.


Risk: Collective action clauses, where debt investors are subject to bond haircuts in a default situation, look set to be introduced for eurozone sovereign debt issued after 2013. Will the DMO follow suit at some point?

RS: We haven’t looked at introducing collective action clauses into domestic UK debt issuance. Of course, you never say never, but I see no reason why they should be introduced here.


Risk: Will their use in the eurozone make UK debt more attractive to investors?

RS: It’s impossible to say what impact they will have. People don’t just base their investment decisions on whether they will be on the wrong end of a bond haircut. Lots of criteria come into play – yield outlook, the stability and future prospects of the currency, the liquidity of the relevant market. All these considerations play a big role in investor decisions.


Risk: A number of politicians in Europe and the US have criticised those who put on naked shorts on government bonds and sovereign credit default swaps (CDSs), with some calling for a ban on short selling. What is your view?

RS: Our position on this issue is that banning or imposing restrictions on short selling in the sovereign bond and sovereign CDS markets is unnecessary and could potentially have a negative impact on underlying liquidity. If market liquidity is damaged, all sovereign issuers are likely to incur higher debt issuance costs. We don’t think short selling in government bonds is the danger that some people perceive it to be, and the case against the practice has yet to be proven.

People forget we do need and rely on the market to fund ourselves. We want as deep and liquid a market as possible. Any proposed restrictions either need to address a proven market malfunction or market abuse, and they also need to be designed in such a way that they do not make matters worse by increasing our cost of borrowing and increasing financial instability.

 

Risk: The Basel III LCR will presumably spark an increase in demand for sovereign bonds. Do you see this as a positive development for the DMO?

RS: This is a very interesting issue. Again, regulators should always ensure their actions do not cause harm to the markets and always be on guard against unintended consequences. On the surface, the LCR sounds wonderful from a sovereign debt management perspective – banks are required to hold just the thing we want to sell. But I’m not convinced this will automatically help us in the long run. The whole purpose of a liquidity buffer from a financial institution’s perspective is that it has something to sell when it needs liquidity, but the chances are it may be selling the sovereign bonds when everybody else needs to sell them, which will leave the market in a bit of a fix.

When everybody wants to sell sovereign bonds during a liquidity squeeze, where does that leave debt managers? We’ll need to sell our debt too, but the investor base could in theory be greatly reduced. A huge increase in people looking to offload sovereign bonds could then push up the cost at which we can issue our debt.

If the rest of the market saw there was a particular buyer or sector of the market that is bound to us, they may price that in and charge us a premium for it. I don’t think we’d derive any benefit from it. Anything that has a negative impact on our distribution channels is bad news for us.


Risk: How does the DMO make its voice heard on the wide array of regulatory issues currently on the table?

RS: Although we are physically located in the City, we are legally part of the Treasury and we have a very good relationship with ministers and civil servants. The need for our existence, and our fundamental goal of reducing the cost of borrowing while minimising risk, is recognised across the political spectrum and is non-controversial. We are able to put across our arguments to legislators and the civil service without any problems. The precise set-up and institutional framework may be slightly different for sovereign debt managers in many other countries, but we find the UK model works very well.

I’m generally optimistic about the effect of Basel III and other regulatory initiatives, but not complacent. We have to be aware of anything, at a time when we still have a very high amount of debt to issue, that is negative for debt management in general.

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